CHAPTER

9
Application:
International Trade
Economics
PRINCIPLES OF

N. Gregory Mankiw

2009 South-Western, a part of Cengage Learning, all rights reserved

In this chapter,
look for the answers to these questions:

What determines how much of a good a country will

import or export?
Who benefits from trade? Who does trade harm?
Do the gains outweigh the losses?
If policymakers restrict imports, who benefits?
Who is harmed? Do the gains from restricting
imports outweigh the losses?
What are some common arguments for restricting
trade? Do they have merit?
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 Introduction
Recall from Chapter 3:
A country has a comparative advantage in a
good if it produces the good at lower opportunity
cost than other countries.
Countries can gain from trade if each exports the
goods in which it has a comparative advantage.
Now we apply the tools of welfare economics
to see where these gains come from and
who gets them.

APPLICATION: INTERNATIONAL TRADE 2

 The World Price and
Comparative Advantage
PW = the world price of a good,
the price that prevails in world markets
PD = domestic price without trade
If PD < PW,
country has comparative advantage in the good
under free trade, country exports the good
If PD > PW,
country does not have comparative advantage
under free trade, country imports the good
APPLICATION: INTERNATIONAL TRADE 3
 The Small Economy Assumption
A small economy is a price taker in world markets:
Its actions have no effect on PW.
Not always true especially for the U.S. but
simplifies the analysis without changing its lessons.
When a small economy engages in free trade,
PW is the only relevant price:
No seller would accept less than PW, since
she could sell the good for PW in world markets.
No buyer would pay more than PW, since
he could buy the good for PW in world markets.

APPLICATION: INTERNATIONAL TRADE 4

 A Country That Exports Soybeans
Without trade,
PD = $4 P Soybeans
Q = 500
exports S
PW = $6
$6
Under free trade,
domestic $4
consumers
demand 300
D
domestic producers
Q
supply 750 300 500 750
exports = 450
APPLICATION: INTERNATIONAL TRADE 5
 A Country That Exports Soybeans
Without trade,
P Soybeans
CS = A + B
PS = C
exports S
Total surplus A
=A+B+C $6
B D
With trade, $4 gains
CS = A C from trade
PS = B + C + D
D
Total surplus Q
=A+B+C+D

APPLICATION: INTERNATIONAL TRADE 6

ACTIVE LEARNING 1
Analysis of trade
Without trade, P Plasma TVs
PD = $3000, Q = 400
S
In world markets,
PW = $1500
Under free trade, $3000
how many TVs
will the country $1500
import or export? D
Identify CS, PS, and Q
200 400 600
total surplus without
trade, and with trade.
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ACTIVE LEARNING 1
Answers
Under free trade, P Plasma TVs
domestic
consumers S
demand 600
domestic
producers $3000
supply 200
$1500
imports = 400 D
imports
Q
200 600

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ACTIVE LEARNING 1
Answers
Without trade, P Plasma TVs
CS = A
PS = B + C S

Total surplus gains

A
=A+B+C from trade
$3000
With trade, B D
CS = A + B + D $1500
C imports D
PS = C
Q
Total surplus
=A+B+C+D
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Summary: The Welfare Effects of Trade
PD < P W PD > PW

direction of trade exports imports

consumer surplus falls rises

producer surplus rises falls

total surplus rises rises

Whether a good is imported or exported,

trade creates winners and losers.
But the gains exceed the losses.
APPLICATION: INTERNATIONAL TRADE 10
Other Benefits of International Trade
Consumers enjoy increased variety of goods.
Producers sell to a larger market, may achieve
lower costs by producing on a larger scale.
Competition from abroad may reduce market
power of domestic firms, which would increase
total welfare.
Trade enhances the flow of ideas, facilitates the
spread of technology around the world.

APPLICATION: INTERNATIONAL TRADE 11

 Then Why All the Opposition to Trade?
Recall one of the Ten Principles from Chapter 1:
Trade can make everyone better off.
The winners from trade could compensate the losers
and still be better off.
Yet, such compensation rarely occurs.
The losses are often highly concentrated among
a small group of people, who feel them acutely.
The gains are often spread thinly over many people,
who may not see how trade benefits them.
Hence, the losers have more incentive to organize
and lobby for restrictions on trade.
APPLICATION: INTERNATIONAL TRADE 12
Tariff: An Example of a Trade Restriction
Tariff: a tax on imports
Example: Cotton shirts
PW = $20
Tariff: T = $10/shirt
Consumers must pay $30 for an imported shirt.
So, domestic producers can charge $30 per shirt.
In general, the price facing domestic buyers &
sellers equals (PW + T ).

APPLICATION: INTERNATIONAL TRADE 13

 Analysis of a Tariff on Cotton Shirts
PW = $20 P
Cotton shirts
Free trade:
buyers demand 80
sellers supply 25 S
imports = 55
T = $10/shirt
price rises to $30 $30
buyers demand 70
$20
sellers supply 40 imports
imports D
imports = 30
Q
25 40 70 80

APPLICATION: INTERNATIONAL TRADE 14

 Analysis of a Tariff on Cotton Shirts
Free trade P
Cotton shirts
deadweight
CS = A + B + C
+D+E+F loss = D + F
PS = G
S
Total surplus = A + B
+C+D+E+F+G
A
Tariff
B
CS = A + B $30
PS = C + G C D E F
$20
Revenue = E G
D
Total surplus = A + B Q
+C+E+G 25 40 70 80

APPLICATION: INTERNATIONAL TRADE 15

 Analysis of a Tariff on Cotton Shirts
D = deadweight loss P
Cotton shirts
deadweight
from the
loss = D + F
overproduction
of shirts S
F = deadweight loss
from the under- A
consumption
B
of shirts $30
C D E F
$20
G
D
Q
25 40 70 80

APPLICATION: INTERNATIONAL TRADE 16

 Import Quotas:
Another Way to Restrict Trade
An import quota is a quantitative limit on imports
of a good.
Mostly has the same effects as a tariff:
Raises price, reduces quantity of imports.
Reduces buyers welfare.
Increases sellers welfare.
A tariff creates revenue for the govt. A quota
creates profits for the foreign producers of the
imported goods, who can sell them at higher price.
Or, govt could auction licenses to import to
capture this profit as revenue. Usually it does not.
APPLICATION: INTERNATIONAL TRADE 17
 Arguments for Restricting Trade
1. The jobs argument
Trade destroys jobs in industries that compete
with imports.
Economists response:
Look at the data to see whether rising imports
cause rising unemployment

APPLICATION: INTERNATIONAL TRADE 18

 Arguments for Restricting Trade
1. The jobs argument
Trade destroys jobs in the industries that compete
against imports.
Economists response:
Total unemployment does not rise as imports rise,
because job losses from imports are offset by
job gains in export industries.
Even if all goods could be produced more cheaply
abroad, the country need only have a
comparative advantage to have a viable export
industry and to gain from trade.
APPLICATION: INTERNATIONAL TRADE 19
 Arguments for Restricting Trade
2. The national security argument
An industry vital to national security should be
protected from foreign competition, to prevent
dependence on imports that could be disrupted
during wartime.
Economists response:
Fine, as long as we base policy on true security
needs.
But producers may exaggerate their own
importance to national security to obtain
protection from foreign competition.

APPLICATION: INTERNATIONAL TRADE 20

 Arguments for Restricting Trade
3. The infant-industry argument
A new industry argues for temporary protection
until it is mature and can compete with foreign
firms.
Economists response:
Difficult for govt to determine which industries
will eventually be able to compete and whether
benefits of establishing these industries exceed
cost to consumers of restricting imports.
Besides, if a firm will be profitable in the long run,
it should be willing to incur temporary losses.

APPLICATION: INTERNATIONAL TRADE 21

 Arguments for Restricting Trade
4. The unfair-competition argument
Producers argue their competitors in another
country have an unfair advantage,
e.g. due to govt subsidies.
Economists response:
Great! Then we can import extra-cheap products
subsidized by the other countrys taxpayers.
The gains to our consumers will exceed the
losses to our producers.

APPLICATION: INTERNATIONAL TRADE 22

 Arguments for Restricting Trade
5. The protection-as-bargaining-chip argument
Example: The U.S. can threaten to limit imports
of French wine unless France lifts their quotas
on American beef.
Economists response:
Suppose France refuses. Then the U.S. must
choose between two bad options:
A) Restrict imports from France, which reduces
welfare in the U.S.
B) Dont restrict imports, which reduces U.S.
credibility.
APPLICATION: INTERNATIONAL TRADE 23
 Trade Agreements
A country can liberalize trade with
unilateral reductions in trade restrictions
multilateral agreements with other nations
Examples of trade agreements:
North American Free Trade Agreement
(NAFTA), 1993
General Agreement on Tariffs and Trade
(GATT), ongoing
World Trade Organization (WTO), est. 1995,
enforces trade agreements, resolves disputes

APPLICATION: INTERNATIONAL TRADE 24

CHAPTER SUMMARY

A country will export a good if the world price of the

good is higher than the domestic price without trade.
Trade raises producer surplus, reduces consumer
surplus, and raises total surplus.
A country will import a good if the world price
is lower than the domestic price without trade.
Trade lowers producer surplus but raises consumer
and total surplus.
A tariff benefits producers and generates revenue for
the govt, but the losses to consumers exceed these
gains. 25
CHAPTER SUMMARY

Common arguments for restricting trade include:

protecting jobs, defending national security,
helping infant industries, preventing unfair
competition, and responding to foreign trade
restrictions.
Some of these arguments have merit in some
cases, but economists believe free trade is usually
the better policy.

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